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Future of Risk Management in Indian Banking Industry

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Future of Risk Management in Indian Banking Industry

Thursday, June 10, 2010


By Aashika Agarwal & Sudhir Sirohy

The calculation of risk will be done by credit scoring models such as Altman's Z Score Model &
Merton Model but in a more sophisticated and developed manner.  

Executive Summary

The Indian Economy is booming on the back of strong economic policies and a healthy regulatory
regime. The effects of this are far-reaching and have the potential to ultimately achieve the high
growth rates that the country is yearning for. The banking system lies at the nucleus of a country's
development robust reforms are needed in India's case to fulfill that. The BASEL II accord from the
Bank of International Settlements attempts to put in place sound frameworks of measuring and
quantifying the risks associated with banking operations. The paper seeks to showcase the changes
that will emerge as a result of banks adopting the international norms.

The structure of the paper is three-fold, where we begin by projecting the risk management scenario
and its effects on internal operations of a bank, followed by the changes brought about in the
banking sector of India and finally the macro effects on the economy. This enables one to discern the
complete scenario that will emerge in the years ahead.

The Risk Management scenario will strengthen owing to the liberalization, regulation and integration
with global markets. Management of risks will be carried out proactively and quality of credit will
improve, leading to a stronger financial sector.

The calculation of risk will be done by credit scoring models such as Altman's Z Score Model &
Merton Model but in a more sophisticated and developed manner. The management information
systems (MIS) will be put in place and the level of efficiencies will increase more than
proportionately. Risk based pricing will be used for all credit facilities extended by banks. The
treasury departments of banks are poised to benefit from the BASEL II accord as would be
showcased in the paper.

The future will see a structural change in the banking sector marked by consolidation and a
shake-out within the sector. The smaller banks would not have sufficient resources to withstand the
intense competition of the sector. Banks would evolve to be a complete and pure financial services
provider, catering to all the financial needs of the economy. Flow of capital will increase and setting
up of bases in foreign countries will become commonplace.

Finally, the economy will stand to benefit as the banking sector develops. Savings will be mobilized
in the right direction and the required funds needed for the country's development will be made
available.

1.0 Introduction

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The Indian Financial System is tasting success of a decade of financial sector reforms. The economy
is surging and has gathered the critical mass to convert it into a force to reckon with. The regulatory
framework in India has sparked growth and key structural reforms have improved the asset quality
and profitability of banks.

Growing integration of economies and the markets around the world is making global banking a
reality.

Widespread use of internet banking has widened frontiers of global banking, and it is now possible to
market financial products and services on a global basis. In the coming years globalization would
spread further on account of the likely opening up of financial services under WTO. India is one of the
104 signatories of Financial Services Agreement (FSA) of 1997. Thereby giving India's financial sector
including banks an opportunity to expand their business on a quid pro quo basis.

As in different sectors, competition is driving growth in the banking sector also. The RBI requires all
banks to comply with the standardized approach of the BASEL II accord by 31st March, 2007. The
quantification and accounting of various risks would result in a more robust risk management system
in the industry.

This paper attempts to project the implications of this transition and its effects on the internal
operations of a bank followed by its effects on the banking industry and the economy.

2.0 RISK Management Scenario in the Future

Risk management activities will be more pronounced in future banking because of liberalization,
deregulation and global integration of financial markets. This would be adding depth and dimension
to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk,
therefore management of risks in a proactive, efficient & integrated manner will be the strength of
the successful banks. The standardized approach would be implemented by 31st March 2007, and
the forward-looking banks would be in the process of placing their MIS for the collection of data
required for the calculation of Probability of Default (PD), Exposure at Default (EAD) and Loss Given
Default (LGD). The banks are expected to have at a minimum PD data for five years and LGD and
EAD data for seven years.

Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also
the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded substantially if
the banks want to migrate to the IRB Approach.

        

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Although many banks would be working towards the IRB Approach, the authors are of the opinion
that RBI would have allowed a few banks to implement and follow the IRB Approach by the year
2015. Indian banks would be moving upward on the strategic continuum of risk scoring models as
can be seen in the diagram on the previous page.

2.1 BASEL II Effects on Internal Operations

Once implemented, the BASEL II norms would greatly influence the internal operations of a bank the
effects of which, would be clearly visible in 2015. In this section, we analyze the extent of change
brought about by the norms.

2.11 Risk Management Department's Role

The Risk Department would gain prominence within the banks as they would be playing an
extremely critical role in the management of the risks of the bank. Streamlining of information and
data flow through the Risk Department would be essential in calculation and management of risks.

2.111 Calculation of Risks & CAR

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Calculation of risk would be an essential requirement in the banks as they would be in the process of
calculating not only the Credit Risk but also the Market Risk and the Operational Risks that the bank
would be facing. The capital to be set off for advances made by the bank would depend largely upon
the fair and accurate calculation of these risks. In 2005 five credit risk models have received global
acceptance as benchmarks for measuring stand-alone as well as portfolio credit risk. They are: -

I. Altman's Z Score Model


II. Merton Model
III. KMV Model for measuring default risk
IV. Credit Metrics
V. Credit Risk+

These models would get more sophisticated and the banks would have more options as other models
would gain acceptance. For Market Risks the banks would be employing other models such as VaR,
Monte Carlo Simulation etc. As for the Operational Risks the banks would be following internal risk
frameworks in assessing significant operational risks and their mitigation.

2.112 Risk-Based Pricing

Risk-based Pricing is the technique of charging different interest rates from two different customers
on the same type of loans, depending on the risk attributed to each of them. Under this method
credit scores are calculated for individuals, taking into consideration various factors which are
assumed to represent the individual's willingness and capacity to repay the loan installments. As the
banks would be in the process of moving toward the IRB Approach they would be armed with the
knowledge of the risks associated with the various types of exposures. This knowledge would help
the banks in passing on the charge arising from higher credit risk to the customers. The authors are
of the opinion that Risk-Based Pricing would be the norm of the banking industry in another ten
years.

2.12 Technology (MIS)

Indian banks would invest in development of Information Systems as MIS would play an essential
role in the calculation of LGD, EAD and PD. As the banks are expected to integrate various financial
services to provide a one-stop shop to the customers, MIS would be helpful to the banks in
cross-selling and other marketing-related activities. The settings up of such systems are expected to
reach completion by 2015 for most banks.

2.13 Strengthening of Treasury Operations

The spreads relating to core banking business of credit and deposit interest rates would narrow
down. Also, if the bank enjoys low PD and LGD it would have larger amount of funds available to it,
as its regulatory capital requirements would come down. The banks would have to search for
alternative profit generating avenues in the form of float fund management, thereby strengthening
their treasury operations, which will be a thrust area in the coming years.

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2.14 Human Resource Development

More emphasis would be given to the human resources of the bank as Basel II would require banks
to calculate and manage risks continuously. One of the key requirements of the new Accord is
monitoring... the risk of direct or indirect loss resulting from inadequate or failed internal processes,

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people and systems... The composition of skills required to perform in the new environment would
undergo a change.

This change will force banks to invest in educating its work force in various risk-scoring models and
enabling them to acquire skills to tap the full potential that the market offers. The Operational Risk
requirements of Basel II Accord extend deep into corporate procedures that may not seem obviously
connected to financial risk management. HR systems, for example, must ensure that procedures and
documents surrounding such tasks as staffing, education and system maintenance, are properly
recorded and documented, and that organization charts and lines of responsibility can be tracked
and reported as required. Banks would be required to address issues such as manpower planning,
selection and deployment of staff and training them in Risk Management and Risk Audit. Hence, it is
assumed that the banks that would have sound HR policies and practices in place.

2.15 Emphasis on Corporate Governance

In the future, there would be greater emphasis on corporate governance in banks because banking
supervision cannot function as well if sound corporate governance is not in place and, consequently,
banking supervisors have a strong interest in ensuring that there is effective corporate governance
at every banking organization. Supervisory experience underscores the necessity of having the
appropriate levels of accountability and checks balances within each bank.

2.2 BASEL II Effects on Banking Industry

The banking sector in will continue on the growth trajectory and would further integrate into the
global financial system.

2.21 Consolidation

The trend in the Indian banking industry suggests that the industry is moving from a "large number
of small players" towards a "small number of large players". There would be three reasons for the
consolidation in the industry: -

I. Increased competition from foreign as well as domestic banks after deregulation and liberalization
of the Indian banking industry. It would be very difficult for smaller banks to correctly price their
loans and they would lose out on customers with low probability of default to larger banks, who
would offer them lower interest rates and they would end up with customers with high probability of
default, which would be offered higher interest rates by the larger banks. The only way the banks
would be able to survive would be by growing in size, and mergers and acquisition would be the
preferred path to growth. This trend has already started as can be seen by the spurt of mergers that
have taken place during recent times (Times Bank and HDFC Bank (2000-01), ICICI Bank with Bank
of Madura(2002) and subsequently with ICICI Ltd.(2002), Benares State Bank and BoB(2003), Global
Trust Bank with Oriental bank of Commerce (2005).)

II. To attain the benefits of IRB Approach like lower capital adequacy requirements, better image,
etc., the banks would require investment in its risk management models as well as information
systems. It could be difficult for a small sized bank to undertake these investments.

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III. Integration of financial services, for example insurance, brokering, consultancy etc. will take place
making the banks a delivery channel for a host of financial products and services.

2.22 Increased Capital in the Market

The authors are of the view that in the future the banks would follow the strategy of low defaults and
narrower spreads. This would bring down their CAR requirements, freeing up more funds that could
be invested in the economy. Another point to be noticed is that the banks would have in place more
sophisticated credit scoring models and they would be able to invest in more profitable and less risky
avenues thereby improving the efficiency of the capital markets.

2.23 Systemic Risk

Although the banks would benefit by having more free funds available, taking a macro view of the
system we might see the systemic risk going down. The rationale behind this statement is that the
bank's risk models would have developed and become more sophisticated. They would not only take
into account various characteristics of the borrower but also the future economic condition. The
banks would become more robust and efficient thereby contributing to the reduction of systemic
risk.

<!--pagebreak-->2.24 International Scope

With better utilization of capital, rollover of bank's funds through securitization and efficiency in
operations, Indian banks would become competitive in the international markets. The consolidation
of banks would give them the requisite size and compliance with the Basel II Accord would give them
greater efficiencies in management thereby making them competent for the international market. As
per Indian Banks' Association report "Banking Industry Vision 2010", there would be greater
presence of international players in Indian financial system and some of the Indian banks would
become global players in the coming years. So, one can envision Indian banks going global in search
of new markets, customers and profits.

The following points provide further insight on the expected banking scenario. Although, not direct
consequences of the BASEL norms these structural changes will be a fall-out of the reforms in the
banking sector.

The implementation of the 2nd phase of the RBI's roadmap to reform in 2009, would allow foreign
bank ownership of any local private bank, within an overall limit of 74%. These foreign banks would
bring with them technological and management skills and improved efficiency.

RBI's role in the banking industry


RBI would be in the process of shifting to risk-based supervision (RBS) wherein the focus of its
supervisory attention on the banks is in accordance with the risk each bank poses to itself and the
system. The inceptions of RBS will require banks to reorient their original setup towards RBS and put
in place an efficient Risk Management architecture, internal auditing focusing on risk, strengthening
MIS and set up of compliance units.

Slimming & Trimming of the Indian Banks


Emphasis would be given to automation and outsourcing of different services would be done so as to
enable the banks to tackle the increasing volumes of business effectively. Customer-Banker contact
will be reduced to the bare minimum as it would be a paperless banking era, dominated by plastic
money, electro-banking, and tele-banking.

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2.3 BASEL II Effects on Economy

The Indian households have not shown great faith in the country's financial systems, this is shown by
the enormous gold consumption that the country has. Indians possess around $200 Billion of gold,
equal to nearly half of the country's bank deposits. The Indian government reckons that
approximately $150 Billion is required over the next ten years to upgrade the country's
infrastructure. The government has proposed to use its foreign-exchange reserves to finance these
investments, but this would add only $3-$5 billion annually. Domestic savings are the only plausible
source of extra funding.

The authors believe that this is due to the lack of transparency and household's perception of the
Indian financial system as being weak. Basel II encourages more transparency and good corporate
governance policies as disclosures are required to be made by the banks, under Pillar III (Market
Discipline). This would help in gaining the trust of Indian households who would in turn increase their
participation in the financial assets, which would benefit the country as the savings would be pooled
to finance more important and productive investments.

There would be increased availability of funds for the rural markets as the banks would increase their
penetration in the rural sectors. This would be done as the banks would have excess funds at hand,
due to reduced Capital Adequacy Requirements by employing good credit risk models in place.

Both the corporate and consumer clients would be enjoying decreased interest rates and increased
availability of funds.

3:0 Conclusion

India's growth potential over the next 10 years sets the country at the forefront of the developing
world. The authors firmly believe that Indian banks would capitalize on the opportunity available to
them and the continuations of the reforms initiated over one decade ago will unleash their potential
and bring India to a more advanced stage of development.

Concluded.

 
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